Always wanting to get your money's worth seems like a reasonable way of thinking about costs and experiences. When you pay for something, you expect to get something in return. If you don't, you feel like you've thrown away your money, time, or effort.
But even getting your money's worth has its limits.
Imagine, for example, that you shelled out for some luxurious grass-fed organic milk. You're just about to start foaming it up for a latte when you realize it has expired. Do you press on, thinking about the high price you paid when you bought the milk? Or do you pause, thinking about the unpleasant drinking experience ahead?
Life is full of situations like this. Unfortunately, they aren't always as easy to parse as a decision not to drink spoiled milk. If you've ever sat through a football game in the freezing cold just because you paid for the ticket, then you've already wrestled with this problem.
At issue here is a behavioral tic known as the sunk cost fallacy. Understanding how it works and avoiding its most pernicious effects can help make you a better steward of your resources.
A sunk cost is one you've already paid and can't be recovered. A rational take on such outlays would be: Money I'll never recover won't dictate my future decisions. Only additional costs matter. If I throw $100 into a wishing well and my wish isn't granted, why should I toss another $100 after it?
Yet sunk costs influence decisions all the time. Whenever you hear a politician railing against a project being canceled just because of the millions already spent, you're in the presence of the sunk cost fallacy. In fact, this problem is occasionally referred to as the "Concorde fallacy," after the now-scrapped supersonic jet that once flew between Europe and the United States. The British and French governments continued to spend money on the project long after they knew the economic rationale for it was dead. The sums they'd already spent on the Concorde became a justification to keep spending more—the very definition of throwing good money after bad.
So, what's going on here?
Researchers have shown how people will subordinate their pleasure if it means avoiding waste. One study offered up the following problem: Imagine you bought a $100 ticket for an upcoming ski trip to Michigan.1 A few days later, you spend another $50 booking a potentially more enjoyable ski trip to Wisconsin. To your dismay, you realize they are on the same weekend. It's too late to sell, and the tickets are nonrefundable. Where do you ski?
The rational choice would be to accept that you can't get your money back and opt for the more enjoyable trip to Wisconsin. However, most of the subjects participating in the experiment opted for Michigan—apparently because that ticket cost more.
Why would the cost outweigh the average skier's better interest?
Groundbreaking research by Daniel Kahneman and Amos Tversky has shown that humans are imperfect judges of self-interest and have a strong aversion to loss.2 In fact, we tend to feel the pain of losses even more keenly than the pleasure of gains.
In the case of the sunk-cost fallacy, the fear of acknowledging a "loss" can keep us looking backward at events we can't change, when our interest lies in thinking about what comes next.
Investing is inherently forward-looking. Whether you're saving money in a savings account, putting it in the stock market, or investing in your own business, you're likely thinking about accumulation, future gains, and growth. Sometimes these investments don't pan out. That can hurt, but what you do afterward matters a lot.
Throwing more money at a losing investment, trading strategy, or business idea in the hope of justifying money already spent can open the way to bigger losses. This doesn't mean you should become so indifferent to losses that you take on excessive risk. However, it's important to always judge your investments according to their future usefulness or prospects, and not your past feelings about them. Don't let the sunk cost fallacy transform that albatross around your neck into a Concorde.
In that spirit, here are a few tips to consider:
- Review your investing strategy at least once a year. Most investments aren't "set it and forget it," so you need to make sure your strategy is hitting the marks you've laid out for it. Are you still on track? Don't stick with a strategy just because it worked in the past. Markets change. You can become more—or less—willing to take risks. Your needs can change over time. What worked before might not cut it anymore. Make sure your investments are geared toward the future, not the past. Talk with a professional if you're not sure.
- Take a hard look at any losing investments and ask whether you could do better elsewhere. When you stick with a losing asset or investment strategy, you're not just committing to a position that isn't working—you're also sacrificing the potential gains you could have earned with a different approach.
- Commit to a plan when trading. Avoiding the sunk cost fallacy can be challenging when markets are moving quickly and a trade moves against you. One way to stay disciplined is to draft a trading plan ahead of time outlining what you're trying to accomplish and how you are going to accomplish it. Key elements of your trade plan should include your investing time horizon, entry and exit strategies, position size and trade performance review. Remember, trading involves losses. The goal is not to win on every trade, but to have more profitable trades than unprofitable trades—in other words, to make more on your winners than you lose on your losers.
- Use specific order types to exert more control over your trades. Consider using limit orders, or stop or stop-limit orders to help bring more discipline to your trading. Each order type can be used in particular market conditions to meet certain goals, such as executing trades at prices you specify when markets get volatile.
- Recognize the value in losses. If you have a losing investment in a taxable account, think before you double down. Assets that have lost value can be used to reduce your tax liability through a process known as tax-loss harvesting. This involves selling a losing investment to offset taxable gains elsewhere in your portfolio and buying back a comparable, but not identical position.
1Hal R. Arkes and Catherine Blumer, "The Psychology of Sunk Cost," Organizational Behavior and Human Decision Processes, 1985.
2Daniel Kahneman and Amos Tversky, "Prospect Theory: An Analysis of Decision under Risk," Econometrica, 1979.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
There is no guarantee that execution of a stop order will be at or near the stop price.
Investing involves risk, including loss of principal.
This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.1021-1XRX